Time for another basic concept. In simple terms, there are two types of price movement and two types of traders corresponding to those movements. Although there will always be overlaps, you can think of the people buying shares as being split into investors and short-term traders. On the one hand, the investor is looking at the long-term and cares less about the daily or weekly fluctuations in price caused by instantaneous supply and demand; on the other hand, the short-term trader is focused on those fluctuations and does not expect to hold the shares long enough for any long-term price movement to be realized.
Prices are always moving, and the short-term trader seeks to pick shares which can give a quick profit from the constant fluctuations. Although the long-term investor would love to buy at the lowest point, his focus will be on the long-term prospects of the company, growth in sales and markets, etc., so fluctuations are of less concern. Because of these different viewpoints, you could possibly find an investor buying when a short-term trader is selling, or vice versa, even though both ply their trade with the intention of making a profit overall.
In practice, this means that an investor will concentrate on “fundamental analysis”, exploring the basic soundness of a company, whilst a short-term trader will base most decisions on “technical analysis”, which attempts to anticipate the fluctuations. Although technical analysis tends to appear complicated at first sight, and fundamental analysis generally uses clear logic, you will find that fundamental analysis can actually more be complex, with many more types of data to be taken into account.
Let’s look first at fundamental analysis. To perform this, you need to have access to a number of different figures, many of which are freely available on the company’s website or on one of the many financial websites set up to advise investors, such as Yahoo! Financial.
What can you think of that would characterize the performance of company, and therefore impact its future value? Profit and loss are obviously important, and you can obtain figures for recent years, so you can see if the company is improving or getting worse. How much the company is worth in terms of equipment and materials matters, so you can see how well the company is using its equity in generating goods and services.
For example, here is just some of the information that you can get freely from Yahoo! Financial pages. This set of figures is for Home Depot, the American based building supply company.
You can perhaps see why I say fundamental analysis can be much more complicated than technical analysis. Looking at some of the more common numbers that investors choose to use when assessing the investments, here are some of the factors and ratios examined.
One of the best-known measures of a company is the P/E Ratio. This stands for price/earnings, that is the price of the share divided by the earnings or dividends per share. For instance, if shares are priced at £75, and the earnings per share for the year are £5, the P/E ratio is 75/5, which works out to 15. This is a fairly typical number for companies in general on the stock market. Analysts may look in more detail by comparing the P/E ratio with other companies in the same type of business, say computer manufacturers, and see what their P/E ratios are for comparison. If the P/E ratio is lower than others then the company stocks may be undervalued. Of course, the price may be down for other reasons such as strike action in the manufacturing plant, obsolete designs for which the sales are dropping, and many other factors. You need to look at the total picture before deciding how important the P/E ratio really is.
I mentioned the type of business, as typical P/E ratios vary depending what sort of company you are considering. There are many different “market sectors”, including energy, retail, food service, etc. and each sector will tend to have a different average P/E ratio. Market sectors are also important if you are investing a large proportion of your funds, as you should try to ensure that your investments are “diversified” across different markets. You may remember the “dot-com” boom early in the 21st century which became a bust, and this was an extreme example of what can happen if you put all your eggs in one basket.
Another point with the P/E ratio is that sometimes earnings are projected, sometimes they are based on the previous year’s earnings, and sometimes the earnings are partly historic and partly projected. If you are comparing P/Es you need to make sure you compare like with like. You can find the relevant information on a company’s website, though it is often easier to go to a financial website where the figures have been extracted for you for all companies that you are considering. Some financial websites require a subscription, but many do not, particularly if you are only looking for the basic information.
Some investors are content to look no further than P/E ratios before deciding on their best investment. However, there are many other figures available and you owe it to yourself to be careful in your analysis when you are picking the best stock for your portfolio. The founder of the well-known periodical Investors Business Daily, William J O’Neil, was known to have said that the P/E ratio was less important in his opinion than the company’s actual earnings and the annual rate of increase in the earnings.
Another ratio which is less well known but believed by many investors to be a better indicator of share value is the P/S Ratio. This stands for Price/Sales Ratio. Substituting the sales figures for the earnings figures gives the advantage, to some ways of thinking, that the ratio is less likely to be manipulated and therefore gives a truer picture of the company’s financial position. The sales numbers do not take into account debt and expenses, which can be “adjusted” by unscrupulous accountants.
A third ratio to mention is the P/B Ratio, the Price-to-Book Ratio. As before, the price is the value of the shares, the quoted price multiplied by the number of shares issued. The book price is what the firm’s accountants have stated the company is worth. There are standard methods to work this out, though once again it can be “adjusted” with some variations. Usually they take the company’s asset value as a starting point, and then take away the company’s debts. If the company has a low P/B ratio, this might mean that the stock is undervalued, though there could be other factors applying. If the P/B ratio is high, then the stocks may not be good value, and if it is more than two then you are probably spending too much if you buy stocks in the company.
Some investors think it is important to explore how much debt a company has. Some companies, particularly the ones that have been established for some time, may be virtually debt-free whereas others can be financing their expansion and growth by taking on large amounts of debt in the belief that it will be more than paid back with future profits. Many companies will trade somewhere in between these two extremes. Companies may be just as viable with either type of debt; however, the higher the amount of borrowing the more difficult it will be for a company to make a profit after repaying the debt, and perhaps more importantly the more vulnerable it will be to interest rate changes, over which it may have little control.
The customary tool to look at debt is called the debt ratio, and this is simply the amount of debt that the company holds compared to the stock market price, the quoted price times the number of shares. Typically, a company may have the debt ratio of about 25%. If it goes to as high as 50%, you may think that the company is too sensitive to changes in the interest rate to be a long-term investment. If you’re not sure, you can always compare the debt ratio to other companies in the same market and sector to see how it compares with its rivals.
A further guide to the worthiness of a company for investment is to see how much institutional investment there is in the shares. The idea is that institutional investors have time and money to do extensive research, and therefore anything that they invest in heavily is probably a good choice. Once again, it is best if you can look at this factor in comparison with others in the same market sector, as institutional investors will tend to prefer particular types of company.
This is not an irrelevant factor, as institutional investors account for around 70% of all trading volume. However, just because a company does not have much institutional investment, you should not write it off. Some institutions have self-imposed restrictions on the types of investment they will make, and also there are laws governing the amount of involvement. Smaller companies would tend not to have institutional investment, simply because the institution may have too much money to bother with fully researching what would only be a minor part of the portfolio.
Finally for this consideration, you could look at the “beta” of a company, which you will find quoted in many places. The beta is a comparison of the stock price volatility with the general market, which is a comparison of how much the price fluctuates compared with everything else. If the beta is 1.0 it means that the stock price goes up and down in a similar way to the general market. If the beta is greater than 1.0, the stock price will tend to swing more wildly than the market. A low beta means that it does not move as much as the market, with a beta of zero implying that the stock price is not influenced by market moves at all. You can even find stocks with a negative beta, which means the price moves in the opposite direction to the market. You need to consider beta in conjunction with your propensity for risk, deciding whether you are comfortable taking a wild ride on prices, or whether you prefer more stability.
The figures given above are easy to find on Yahoo! or other competitive financial websites. You can appreciate that the study of them can take some time, and of course computers are used extensively by those whose job it is to analyse stocks. If you choose to look at recommendations given by commentators or experts, you should bear in mind that they are paid to write the commentary but do not necessarily have all the answers. You are able to double check most of their assertions, and should decide for yourself whether the company profile fits with your investing objectives.
The factors above are some of those considered when performing a fundamental analysis on a stock. This is for looking at the long-term, whether the stock is a good investment in which to deposit your money, coming back to it months or years later when it should have increased in value. As mentioned above, the other type of analysis is called technical analysis, and this is the form of scrutiny performed by short-term traders.